"Perfect Storm" Roils U.S. Economy
Two UA economists predict Arizona and the nation will weather the housing market, but not without some pain along the way.

By Jeff Harrison, University Communications
Dec. 7, 2007


They were entertaining, but they were not cheerful.

Marshall Vest, director of the Forecasting Project, and Gerald Swanson, a professor of economics, both in The University of Arizona's Eller College of Management, delivered some sobering news about the "hangover" the state and national economy are now experiencing.

The news, they told a record number of guest at the 27th annual Outlook Forecast Luncheon in Tucson, is that the nation's economy is suffering from three major shocks, a "perfect storm" of a serious housing downturn, turmoil in world financial markets and crude oil flirting with $100-a-barrel prices.

Waiting for the clouds to clear may take a year or two.

"It seems doubtful any one of these issues could derail the expansion," said Vest. "Maybe even two. But here we have three. The nation's economy is at risk. We're going to be challenged to see how resilient the national economy is if we are to go forward."

In all likelihood, Arizona is already in a recession, along with four other states, including California, Florida, Michigan and Nevada. Together they represent about 20 percent of the national economy.

Michigan, with its large manufacturing base, has been hurt by the slumping auto industry. Arizona and the other states rely heavily on growth, and this is where the bubble in housing market has hurt.

"All the housing indicators are still negative with no sign of the bottom yet," Vest said. "Building permits and existing home sales are still heading south. The inventory of homes is high and moving higher (and) prices are still declining."

Arizona has seen four significant downturns in housing since the mid-1970s.

"What we see today closely parallels the downturns in 1974-75 and the twin recessions in 1980 and 1981-82," Vest said.

"So far, building permits over the last 25 months have fallen 56 percent statewide. In the mid-70s, permits fell 75 percent over 26 months. If you look at the twin recessions in the early 80s, permits declined 69 percent over 38 months."

Vest then said: "We get to the late 80s and 90s, the 'Mother of all real estate recessions,' which lasted seven years and permits fell by 81 percent. The difference was that the real estate bubble then was mostly commercial, including apartments. Now it's reversed with commercial sector doing well."

Meanwhile, consumers, the great champions of the economy over the last several years, are tapped out. Vest said consumer spending in Arizona peaked in February and has been declining at a 10 percent annual rate since. The buying spree of the last two decades, fueled by easy access to money and credit, is probably over, he said.

Still, Arizona should bottom out late in 2008 or early 2009, with a slow, U-shaped turnaround, not a V with a quick recovery.

"The best bet now is that the recession will be short and mild, although the risks are clearly on the downside," Vest said.

"We should look for 2008 as a recession year, then start to crawl out of it in 2009, and then back to expansion in 2010," he added. "We're fairly close to the bottom and should stay there a while because the overhang in the housing inventory. House building will pick back up again in late 2009-early 2010."

Swanson, the Thomas Brown Professor of Economic Education at the Eller College, said that extracting the country from the subprime mortgage morass promises to be painful.

"For the past two years, I've said allowing people to buy homes with interest-only mortgages is letting them rent with the option to buy," Swanson said.

"That's a dangerous game because if the housing market goes down and the mortgage flips, guess what will they do? Stop renting," he said. "Why continue to pay into an asset that is falling in value? So, houses are flipping and people are finding good reasons to just walk away."

The problem there is that foreign banks bought many of these securities based on the assumption that as the interest rates on subprime mortgages went up, so would the value of their securities.

"We've given the world McDonald's, i-Pods, Coca Cola and the securitization of debt. Maybe they didn't want that," Swanson said.

"The moral hazard is that we gave banks the ability to issue loans, package them, sell them and avoid the risk. If you can make transactions taking cash off the top and then not have to assume any risk attached to it, would you do it?"

There's a corollary in the early 1990s, when Japan's real estate market came crashing down. Swanson said it continued to fester for a decade because Japanese government and banking officials initially refused to acknowledge the depth of the problem, a strategy he hopes the U.S. avoids.

"We put up a bunch of incentives for people to try to make some money and now it's starting to unwind and there will be some costs," he said. "We will not get out of this situation until we allow these losses to actually occur."

"Some people," Swanson said, "made dumb bets."

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